CONFLICT OF INTEREST



Conflict Of Interest 525
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Conflicts of interest for individuals and organizations are not uncommon given the multitude of transactions and relationships that occur in politics, government, industry, science, commerce, research, education, and the professions. A conflict of interest arises from a connection between two or more individuals or organizations, or between an individual and an organization. It is a relationship, not an action. So, a person or organization cannot commit or perform a conflict of interest.

A particular conflict of interest is neither good nor bad, but its presence can interfere with perceptions about a person's objectivity and independence. Someone exploiting a conflict of interest or mishandling conflicting relationships can cause injury. For that reason, conflicts of interest are managed by recognizing a potential or existing conflict, judging the risk of it leading to harm, deciding what level of risk is acceptable, and reducing the conflict to a tolerable level. In some cases managing the conflict may not be sufficient to deal with perceptions, so eliminating it may be the only solution. Objective analysis is key, otherwise flawed preconceptions (e.g., there is no conflict of interest unless there has also been harm) and long-standing customs can obscure the fact that a conflict of interest exists.

DEFINITIONS AND PERTINENT
ASSUMPTIONS

Black's Law Dictionary describes conflict of interest as being in connection with "public officials and fiduciaries and their relationship to matters of private interest or gain to them" in situations where regard for one duty tends to lead to disregard of another. The term "private interest" would mean any tangible benefit accruing directly to the one with a conflict of interest, or indirectly through associates, related organizations, friends, or family members. Tangible benefits can include, for example, direct financial rewards, improved employment, social positioning, public recognition, advocacy and publicity, business referrals, or political influence.

John R. Boatright, in his essay entitled "Conflict of Interest: An Agency Analysis," expanded the definition beyond public officials and fiduciaries to all "agency" relationships (e.g., doctor-patient, lawyer-client, employee-employer) where the agent has the duty and obligation to act in the best interest of a principal. Boatright's definition applies to organizations acting as agents or principals, as well as to individuals. The first type of conflict of interest exists when agent A's private interest is in conflict with B's best interest, and A, as B's agent, has an obligation and duty to act in principal B's best interest. The second type of conflict of interest occurs if agent C has a dual obligation to act in the best interest of two different parties, D and E, but C's obligation to principal D conflicts with C's obligation to principal E. (An obvious example would be agent C representing both D and E on opposing sides in the same dispute.) When C has no agency relationship and no duty to either D or E, then the interests of those two parties are simply competing interests, not a conflict of interest.

When conflicting interests have the potential to interfere with the duty, that condition is sufficient to create a conflict of interest, by definition. Actual interference with the duty through self-dealing need not occur. Moreover, the conflicting interest does not need to directly affect the principal for a conflict of interest to exist. Abuse of position through self-dealing or use of confidential information for personal advantage can exploit a conflict of interest without having any affect on the principal. For example, an "insider" trading and profiting based on privileged information does not harm the company whose securities are being traded.

Boatright stated, "To exploit an agency relation for personal gain is to violate the bond of trust that is an essential part of the relation." Thus, conflict of interest and bribery become intertwined. When an agent accepts a tangible benefit, a "bribe," from a third party, but does nothing in return for the favor, the agent can be said to have a conflict of interest. But when the agent returns the favor, violating the principal's trust, the agent can be charged with bribery.

HISTORICAL PERSPECTIVES

The obvious conflict of interest created by accepting a bribe has been deemed unacceptable conduct by many cultures throughout history. In Babylonia during the 18th century B.C. the Code of Hammurabi punished judges who accepted bribes to alter judgments. In ancient Greece, Plato suggested that public servants convicted in court for accepting bribes be executed. Roman law contained many penalties against bribery of public officials and judges. In medieval England both the briber and the officers accepting the bribes were subject to fines and imprisonment.

The Constitution of the United States prohibits bribery of officials and prohibits the receipt of titles (Article I, section 9, clause 8). An act prohibiting congressmen and federal officials from accepting bribes passed in 1853. Yet, legislatures of state and local governments were full of scandals resulting from conflicts such as free railroads passes for legislators or purchases of U.S. Senate seats. Common law provisions prohibiting those practices existed in some states at the time but were rarely enforced. Such conflicts of interest persisted in the United States through most of the 19th century. The need for capital for economic expansion presumably overrode any other concerns. To illustrate, between 1850 and 1900, railroad executives created construction companies through which they personally profited by steering business from the railroads to their own companies. These practices of self-dealing attracted attention only after several railroad bankruptcies. Executives and financiers began to condemn such conflicts of interest and they diminished by the 1880s.

In the early 20th century two government investigations highlighted some conflicts of interest that affected the financial sector. The Armstrong life insurance investigation in New York unearthed a variety of harmful practices between 1904 and 1906. Corporations and policy holders were forced to suffer losses when insurance companies participating in investment syndicates were left holding unmarketable securities. The investigation also found some insurance company directors were controlling subsidiary trust companies and diverting those funds for personal loans and personal stock purchases. The Armstrong investigation ultimately led to new laws in New York that prohibited underwriting of securities issues by life insurance companies and self-dealing by company officials. These laws were soon copied by other states. The Pugo Committee, a subcommittee of the House Banking and Currency Committee, investigated a similar problem in 1912 and 1913. The committee investigated conflicting interests and concentrations of monetary power in the large investment banking houses. The Pugo Committee's report influenced legislation that produced the Clayton Act of 1914, which outlawed interlocking directorates among large banks and trust companies.

Despite that legislation, corporate exploitation of conflicts of interest did not end. During the 1920s the officers of several major banks were using the bank funds to create speculative gains for themselves, often at the expense of their banks. One of the most blatant cases involved National City Bank president Charles E. Mitchell, who through the use of an affiliate, the National City Company, drove the price of the stock with a book value of $70 to a price of $2,925 before it crashed. The public lost $650 million in market value. Without the stockholders' knowledge, Mitchell further received over $3 million from company funds to supplement his regular salary. Mitchell's actions and similar activities by an officer named Albert Wiggins of Chase Manhattan Bank were cited as abuses that would be checked by the passage of the Banking Act of 1933 (also known as the Glass-Steagall Act). That act separated commercial banking from investment banking. Provisions of the act would control conflicts of interest that placed bank depositors at risk with such practices as underwriting then holding the same corporate securities as assets, marketing to bank customers securities in which the bank had a financial stake or was under pressure to sell, or making unsound loans to shore up finances of corporations in which the banks had already invested.

From 1934 to 1941 the Securities and Exchange Commission (SEC) made efforts to control conflict of interest in the securities markets. Broker-dealer firms were buying and selling for their own accounts as well as for those of customers. Attempts to separate dealers from brokers, as was the practice in Great Britain, were resisted and the SEC retreated. Later, a major embezzlement scandal involving an exchange member did bring about a program of self-regulation by the Association of Security Dealers. With the arrival of World War II, conflict of interest issues in the financial sector attracted less attention.

Significant concerns about conflicts of interest did not surface again until the 1970s. A study financed by the Twentieth Century Fund, entitled Abuse on Wall Street: Conflict of Interest in the Securities Market, reviewed conflicts in the sale of securities, and conflicts in administration of commercial bank trust departments, real estate investment trusts, pension fund management, investment banking firms, broker-dealer firms, and nonprofit institutions. The study did not advocate that all conflicts be eliminated; it recognized that some conflicts were inescapable. It did call for the industry to voluntarily self-regulate in advance of legislation, and strongly recommended disclosure processes to deter illegal or unethical conduct. The Twentieth Century Fund report also pointed out that legislators should consider the dangers of conflict of interest when drafting legislation and avoid features that would invite abuse. It further asserted that Congress encouraged conflicts when it broadened savings and loan association activities without increasing regulations. Further, the report recommended that a sufficient number of directors, independent of the corporation, be appointed to the boards of both for-profit and not-for-profit organizations and that trustees of not-for-profit entities avoid exploiting their appointments to further their own business interests.

Nevertheless, conflict of interest abuses continued. During the 1980s and 1990s a large percentage of savings and loan failures resulted from officers making risky loans to friends and affiliates, contrary to the interest of the institutions these officers were managing. Insider trading scandals abounded, resulting from the numerous leveraged buyouts and mergers. Judicial attitudes tightened, investigations were launched, and enforcement of the Securities and Exchange acts became more strict. The frequency and ease with which conflict of interest situations were exploited, in some cases by graduates of prestigious business schools, alarmed many. This led to a call for institutions and corporations to provide more education and training in ethical conduct and proper business practices. Throughout the rest of the 1990s many centers for policy studies on ethics were established and ethics courses were added to college and university curriculums.

Science, medicine, and technology made rapid advances during the 1990s through collaborations of government agencies, universities, corporations, research institutions, and hospitals. Those collaborations created obligations to sponsors and intellectual property issues that clashed with academic and scientific ideals. When researchers discover and test new medical or scientific applications with commercial potential, conflicts of interest become inevitable. Not surprisingly, a researcher may also expect personal reward notwithstanding any ties to outside funding. The challenge for researchers, institutions, and sponsors is finding the means to pay for the research, keep the research objective, maintain political and public support, and commercialize the new technology, while managing complex conflicts of interest. In the last half of the decade several federal agencies reevaluated conflicts of interest affecting objectivity in research and issued new regulations for disclosing and managing these conflicts. New federal rules focused on preventing bias in research in light of financial ties between companies, researchers, universities, research institutions, and research hospitals. At the same time these groups reexamined their practices and unique set of conflicts and strengthened policies to conform to federal requirements.

As scientists and researchers were tightening controls over conflicts of interest, the financial sector was questioning the relevance of the Glass-Steagall Act of 1933. Gregory Wilson in the McKinsey Quarterly (no. 2, 1995) urged swift regulatory reform, pointing out that "new bank" competitors (e.g., American Express, Fidelity Investments, Merrill Lynch) had a regulatory advantage and could own "full-service FDIC banks without suffering any restrictions on their product, service, acquisition, or affiliation strategies." Meanwhile, Congress was already making attempts at regulatory reform and reconciling competing interests within the financial services industry. In January 1999 the Committee on Banking and Financial Services introduced H.R. 10, the "Financial Services Act of 1999," which consolidated years of attempts to revise regulations governing the nation's financial systems. The act would establish a "comprehensive framework" permitting affiliations between and among commercial banks, securities firms, insurance companies, and other financial service firms. The stated reason for allowing those affiliations was to "enhance consumer choice, level the playing field among providers of financial services, and increase competition." The act also contained "prudential safeguards designed to avoid risk to the federal deposit insurance funds and the payment system, enhance the safety and soundness of insured depository institutions, and protect consumers." H.R. 10 went to open committee in March 1999. If H.R. 10 is ultimately passed, repealing the Glass-Steagall Act, it can serve to illustrate how legislative views toward conflicts of interest adapt to changing market conditions and perceptions of relative risk.

REGULATIONS

Bribery, graft, and conflict of interest affecting the U.S. government is addressed in U.S. Code, Title 18. Part 1, Chapter 11, which applies to public officials, officers, members of Congress, federal judges, employees in the executive, legislative, or judicial branch, or any federal agency. Specific statutes cover four conflict of interest categories: (1) representational activities (18 U.S.C. 203, 205, and 207); (2) financial interests (18 U.S.C. 208); (3) outside compensation (18 U.S.C. 209); and (4) use of official information (18 U.S.C. 1905 and 21 U.S.C. 331[j]). The U.S. Code also applies to proceedings in which the United States is a party or has a direct interest. Similar directives on ethical problems connected with conflicts of interest have been addressed in many state and local governments in the United States.

Federal agencies regulate conflicts of interest that fall within their domain. For example, Federal Acquisition Regulation (FAR) was established to codify uniform policies for purchase of supplies and services by executive agencies. FAR is issued, maintained, and revised jointly under statutory authorities granted to the General Services Administration, the Department of Defense, and the National Aeronautics and Space Administration. FAR addresses conflict of interest in government procurement in Part 3—Improper Business Practices and Personal Conflicts of Interest.

To promote objectivity in research several federal agencies issued new regulations in the late 1990s specifically for disclosing and managing financial conflicts of interest. The purpose was to ensure that standards would support a view that the design, conduct, and publication of sponsored research was unbiased by any financial interests of the researchers. Regulations were issued in 1995 by the National Institutes of Health (NIH), on behalf of the Public Health Service (PHS). A nearly identical set of policies was issued by the National Science Foundation (NSF). The PHS regulations follow from legislation, but the NSF requirements have no legislative history. Both the NIH regulations and the NSF policy place primary responsibility on the research organization for identifying and managing potential conflicts of interest of its researchers.

The Food and Drug Administration in late 1994 proposed regulations that an applicant (e.g., a pharmaceutical company) submitting marketing applications for a product must disclose financial interests of clinical researchers conducting trials. After several rounds of comment and revision, the rule was published in final form and became effective in February 1999. The objective is to preclude bias in safety and efficacy trials of new drugs, biological products, and medical devices. The final rule requires an applicant to disclose, or certify to the absence of, financial interest and arrangements that might have affected the researcher.

The Internal Revenue Service (IRS) imposes heavy excise taxes on private foundations for engaging in prohibited acts of self-dealing with the foundation's substantial contributors, managers, owners, or business affiliates. In 1996 "Intermediate Sanctions" regulations were passed. The new rules extend to all nonprofit educational institutions and hospitals—501(c)(3) and 501(c)(4) entities—the prohibitions and penalties for self-dealing already in place for private foundations. The regulation (Internal Revenue Code Section 4958) allows the IRS to impose excise taxes on "excess benefits" obtained by influential "insiders" and "organization managers" who knowingly authorize improper transactions.

The Employee Retirement Income Security Act of 1974 prohibits fiduciaries of employee benefit plans, plan managers, and administrators from engaging in certain transactions with "parties in interest," such as the employer, the union, corporate officers, or persons providing services to the plan. Specifically, a fiduciary is prohibited from using the income or assets of a plan for his or her own account and is prohibited from receiving tangible benefits from a person dealing with the plan (i.e., a kickback).

Outside the United States, conflict of interest regulations vary widely. A bribe paid to a government official is an act that creates a conflict of interest for the official, by definition. In many countries, however, it continues to be viewed as an acceptable business practice. Other countries strictly forbid bribery of, but allow "gifts" to, public officials, which may become necessary if the public is to be served at all.

Insider trading is still an acceptable practice in securities markets outside of the United States. Nevertheless, requirements for disclosures of conflicts of interest are stricter in Western Europe than they are in the United States. France requires that administrators disclose conflicts to a board of administrators who in turn report the matter to stockholders and auditors. Auditors and stockholders can disapprove the situation. In England, directors must disclose all potential conflicts and must refrain from voting on matters involving those conflicts. In Germany, transactions between a corporation and any board members can be made only with a supervisory committee providing oversight.

CODES OF CONDUCT

Organizations manage the ethical issues connected with conflicts of interest internally. They expect their employees to act with loyalty to the organization's objectives and interests. Many organizations establish and enforce codes of conduct addressing specific conflicts of interests. Such policies often contain general definitions for conflicts of interest, followed by general expectations stating that employees will not engage in activities that will impede, impair, or conflict with their duties as employees, and will not use the organization's property, products, facilities, confidential information, and other resources for private benefit or for the benefit of another organization. Provisions for periodic disclosure and review of potential conflicts are common. The codes and policies may further provide for procedure to manage conflicts of interest when they do exist.

The professions also manage conflicts of interest through model rules, codes of professional responsibility, or codified practice standards. Codes for the professions focus on the nature of the relationship with a client. Judgments and services rendered must be "independent," "objective," or "impartial," in accordance with each profession's vernacular. This approach obliquely implies a prohibition against conflict of interest as it would impair objective judgment. Relationships between attorney and client are governed by The Code of Professional Responsibility and Model Rules of Professional Conduct, which states that "a lawyer should exercise independent professional judgment on behalf of a client." Chartered financial analysts providing investment management services who encounter any issues of conflict of interest are guided by the Association for Investment Management and Research's AIMR Standards of Practice Handbook. Engineers can obtain guidance by referring to codes of ethics for each major engineering society. For example, the 1991 Code of Ethics of the Institute of Electrical and Electronics Engineers requires members "to avoid real or perceived conflicts of interest whenever possible, and to disclose them to affected parties when they do exist." Certified public accountants (CPAs) must avoid lack of independence when they provide an opinion used by a third party. They are required by the American Institute of Certified Public Accountant's AICPA Professional Standards, AU Section 220 to be "free from any interest or obligation to or interest in the client, its management, or its owners."

CONSEQUENCES

Consequences to organizations can be severe when employees, managers, or officers violate trust and exploit an undisclosed private interest. Joseph T. Wells, in Occupational Fraud and Abuse, reported that conflict of interest schemes, although comprising only 1.7 percent of cases reviewed, had a "median loss of $500,000 … [and] were tied with bribery schemes as the most harmful type of fraud on average." Wells indicated that any bribery scheme can be used in the context of a conflict of interest scheme, but distinguished between the two on motive. Wells explained: "if an employee approves payment on a fraudulent invoice … for a kickback, this is bribery.… If … an employee approves payment on an invoice submitted by his own company (and if his ownership is undisclosed) this is a conflict of interest." Wells related that the majority of conflict of interest schemes studied were either "purchasing schemes" or "sales schemes." The most common purchasing scheme involved overbilling the employer through a company in which the employee had an undisclosed interest. Bid-rigging to favor their own company for their employer's purchases was another frequent purchasing scheme. Sales schemes involved underbilling, delayed billing, or sales write-offs of the employer's sales to a company in which the employee had an undisclosed interest. Other conflict of interest schemes included "business diversions" to independent ventures (sometimes in competition with the employer), or "resource diversions."

The consequences to professionals for violating codes of conduct take a different track. Certainly a client badly served can sue the professional for damages. Professional licensing boards can impose additional sanctions. For the legal profession there are journal articles, bar opinions, and published cases on the topic. Lawyers who violate conflict rules face discipline by the bar or disqualification by a judge from serving a client. Even so, for each profession interpretation of the code and perceptions of relative risk will change as markets shift and practices evolve. Roles and relationships once deemed to "impair independence" can be rationalized as appropriate. For example, firms once known as "public accounting" firms, employing CPAs, continued to merge, acquire new practices, and expand services. Some have become giant international "professional service" firms offering a broad array of choices to their clients. A debate has persisted throughout the 1990s as to whether or not the same "professional service" firm can provide extensive consulting services to a client (e.g., system implementation, merger and acquisitions analysis, tax services, internal auditing, actuarial and benefits support) and also serve as the "independent" auditor forming an impartial opinion on the financial statements.

[ Aldona Cytraus ]

FURTHER READING:

Association of American Universities. Framework Document on Managing Financial Conflicts of Interest. Washington: Association of American Universities, 1993.

Benson, George C. S. "Conflict of Interest." In Business Ethics and Common Sense. Westport, CT: Quorom Books, 1992.

Boatright, John R. "Conflict of Interest: An Agency Analysis." In Ethics and Agency Theory. New York: Oxford University Press, 1992.

Illinois Institute of Technology. Center for the Study of Ethics in the Professions. Perspectives on the Professions 17, no. I (fall 1997).

National Science Foundation. "Investigator Financial Disclosure Policy." Federal Register, II July 1995, 35820-23. Poveda, Tony G. Rethinking White-Collar Crime. Westport, CT: Praeger Publishers, 1994.

Twentieth Century Fund. Abuse on Wall Street: Conflict of Interest in the Securities Market. Westport: Quorom Books, 1980.

U.S. Department of Health and Human Services. Public Health Service. "Objectivity in Research Financial Disclosure Policy." Federal Register, II July 1995, 35810-19.

Wells, Joseph T. Occupational Fraud and Abuse. Austin, TX: Obsidian Publishing. 1997.



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